Monthly Archives: February 2010

“BTW, what would Hayek think if he came back today and found so many people who confidently knew when markets were overpriced? Why do we even need markets? If it so obvious what the correct price is, let’s bring back Soviet-style central planning.”

Michael Bordo and John Landon-Lane have a new NBER working paper that conducts a historical analysis of the Federal Reserve’s exit strategies from 1920 – 2007. Here is the abstract:

In this paper we provide some evidence on when central banks have shifted from expansionary to contractionary monetary policy after a recession has ended—the exit strategy. We examine the relationship between the timing of changes in several instruments of monetary policy and the timing of changes of selected real macro aggregates and price level (inflation) variables across U.S. business cycles from 1920-2007. We find, based on historical narratives, descriptive evidence and econometric analysis, that in the 1920s and the 1950s the Fed would generally tighten when the price level turned up. By contrast, since 1960 the Fed has generally tightened when unemployment peaked and this tightening often occurred after inflation began to rise. The Fed is often too late to prevent inflation.

A great way of understanding the Federal Reserve’s monetary policy actions is to use a graphical representation of the market for reserves. Frederic Mishkin’s textbook on money and banking is an excellent print resource. Meanwhile, Mark Thoma illustrates the model, and Fed policy changes, in this YouTube clip:

According to the WSJ, Ben Bernanke is expected to outline the Federal Reserve’s exit strategy this week. As expected (and discussed previously), the Fed plans to tighten monetary policy by increasing the interest rate on excess reserves. Otherwise, as the economy recovers and the excess reserve ratio declines, the money multiplier would rise and thus broader aggregates would rise as well. Given that there are currently over $1 trillion of excess reserves in the system, a failure of policy to tighten when the money multiplier begins to rise would result in rapidly increasing prices.

As I previously discussed, the interest on reserves methodology is a rather crude way to solve the problem. If the problem is with excess reserves, then the reserves should be removed from the system using normal open market operations. So why isn’t the Fed employing this method? Well, I have long suspected that the reason the Fed was employing this strategy was because of the change in the composition in the Fed’s balance sheet away from traditional Treasury holdings and toward mortgage backed securities. This view is confirmed in the WSJ:

Plans for the Fed’s portfolio of mortgage-backed securities are another element of the internal debate over the exit strategy from super-cheap money. The Fed is on course to buy up to $1.25 trillion of the securities, in an effort to hold down mortgage rates and buoy housing.

Over time, officials want to reduce these holdings and return to holding U.S. Treasury securities as the Fed’s primary asset. But they are reluctant to take steps that might push mortgage rates higher and damage the still-fragile housing market. Eventually, they could gradually sell mortgage securities, but such a move would be unlikely in the early stages of tightening.

So, ultimately, the Fed is conducting fiscal policy by subsidizing mortgage rates. What’s more, given that open market operations would necessarily require not only open market sales of Treasury securities, but also mortgage backed securities, the Fed finds itself in a position in which open market operations are politically and practically infeasible.

Additional fiscal policy measures could make a difference to the unemployed, but instead the administration is proposing policies that might sell well, but only address a tiny fraction of the long-run deficit problem.

I think that in many instances this statement can summarize the differences between those who favor and those who don’t favor fiscal stimulus. Those who favor the stimulus read this statement and think that things just need to be done better. However, myself and others who oppose stimulus recognize that policies that “sell well” are the rule, not the exception when it comes to real world policy design and that this is part of the drawback.